Does Investment Portfolio Diversification Still Work?

A common lesson from a children’s story book has become one of the guiding principles for investing: “Don’t put all your eggs in one basket.” But lately, I’ve come across a few articles where people are questioning the wisdom of diversification. Today, we are going to ask the question – could you make more money investing if you did not diversify?

But, first here’s a quick definition of diversification: “to spread out your investments amongst different types of funds”.

The Theoretical Answer

Theoretically, you can make more money (investing or otherwise) if you do not diversify. Let’s say, for example, there are three mutual funds.

  • Fund #1 increases 15% over the year.
  • Fund #2 increases 20% over the year.
  • Fund #3 increases 10% over the year.

Theoretically, you would make more money IF all of your money was in fund number #2 instead of a third in each fund. Having a third in each fund would only yield a 15% return, while fund #2 yielded a 20% return.

Diversification and Risk

So, why should you diversify your investment portfolio? But that’s a big IF, and in real life, we also have to deal with WHEN.

One thing every new investor must know is that risk and reward have an inseparable relationship. You cannot get one without the other. In other words, if you want to increase your return, you must be willing to increase your risk. Conversely, if you want less risk, you will need to sacrifice your potential for gains.

I believe this one investing lesson could save investors millions of dollars annually. Those who seek to get rich quick by investing in something with unrealistic gains usually end up losing everything.

Two Reasons Why You Should Diversify Your Investments

The long term results are better

The turtle still wins. Anyone who makes a big killing off a single stock will rarely walk away unscathed. They will often reenter the market with another gamble and eventually the risk will catch up.

Take the slow, steady, and diversified approach. It is better to slowly get to a million dollars than risk everything to get to ten million.

Emotional security

Not being diversified can be emotionally wearing. When you are diversified, there is probably something going up when everything else is going down. At least there is something holding its ground better than others.

Diversification has a built in ‘plan B’ in case you were wrong.

Sometimes, emotional security is more valuable than financial gain.

The Danger of Going All In: Investing Without Diversification

When I was a kid, I used to love to play the game Stock Ticker (yes, yes, I still love it). In the game, the market is controlled by the roll of the dice. The dice dictate which shares will decrease in value and which will increase in value. If a share drops below the zero line, you lose everything.

The game really doesn’t have an ending, so we usually just say we are going to total up the value of your shares in x # of minutes.

The winner of the game is almost always the person who will sell all of their other shares and buy all the cheapest share. If in those last rounds that share goes up, you have significantly increased your value. If, however, it goes down, you will lose everything.

The person who risks everything in Stock Ticker either finishes first or last.

Going all in on an investment means you risk everything. I’m sure there is someone who has made a lot of money by investing everything in one stock. There are probably thousands of people like that. They went against conventional wisdom and the payoff was huge.

That’s why investors today think they can do it, too.

However, we also need to realize that for every success story, there are 10 people who lost everything by going all in on a stock they just knew was going to succeed.

The risk of investing without diversification is too much.

What do you think…does investment portfolio diversification still work?

About the Author

By , on Mar 12, 2010
Craig Ford
Craig Ford is a fulltime missionary in Papua New Guinea who writes Money Help For Christians and Help Me Travel Cheap, a frugal family travel blog. He is the author of Money Wisdom From Proverbs, has a Masters of Divinity degree, and (most importantly) eats homemade pizza with his family every Friday night.

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Leave Your Comment (9 Comments)

  1. The Rat says:

    I remember reading a book about Warren Buffet and how he mentioned only owning ‘a few good stocks’ can be all anybody needs in order to be successful and that it’s more so the timing that’s key.

    Well, I know one thing – I’m nowhere close to being Warren B. I place importance on a diversified portfolio and ensuring I have solid weightings in different sectors. It makes me feel more secure and I sleep well at night.

    Nice post

  2. All you have to do is look at the returns of some of the major assets classes over the “lost decade”—

    Bonds 5-7%
    Domestic Large Cap -9.1%
    Domestic Large Cap Value 27.6%
    Domestic Small-Cap 41.2%
    Domestic Small Cap Value 121.3%
    REITS 175.6%
    Intl Large Cap 12.4%
    Intl Large Cap Value 41.4%
    Intl Small-Cap 52.3%
    Intl Small Cap Value 198.6%
    Emerging Markets Large Cap 154.3%
    Emerging Markets Small Cap 176.7%
    Emerging Markets Value 212.7%

    Hardly a “lost decade” for those properly diversified.

  3. Eric J says:

    I believe diversification still works. The author made some great points referencing the three different stocks at varying interest rates. Taking that into account, the question would then become…how do I duplicate across multiple ventures?

    In the world of investing, you win some and you lose some. With the right guidance, and inside know-how, diversification could yield great profits. From a beginner aspect, it could spell ruin. Thoughts anyone?

  4. Robert says:

    I am a strong believer in diversification, but we saw something that should make us all take note in 2008. Every sector was going down, didn’t matter where you were diversified, if you were in stocks you were losing money.

    People need to make sure that their diversification is not a group of mutual funds. Bonds may be a nice start, or REITs, CDs, etc. I happen to own a farm and I am really glad I do, because that is another diversification opportunity, much like a rent house.

  5. WR says:

    Diversification is always going to produce less potential return than a ‘pure’ investment. That is the point. Diversification is risk avoidance.

    A Mutual Fund is a diversified group of investments. Instead of buying one stock, you buy a whole basket of stocks. If one company fails, you still have a bunch of others to rely on.

    I think the question is not “Should you diversify” but rather “How should I diversify?”

    I am a huge fan of index funds. I think you should have a good split between BOND Index funds and EXTENDED EQUITY STOCK Index funds. This way you can create a nice relationship between the two.

    This strategy worked very well for me in the recent downturn. I had mix of in Bond index funds and Stock index funds. Stock funds went to the floor so I hung on to those and used the stable bond fund to essentially retain my composure while I continued to buy the stock fund..At a Huge bargain. (Be greedy when others are fearful…).

    Most people should do a 60 Stock/40 bond split. When the stock fund is trading at near 10 year high levels . Pump more into your BOND fund

    http://www.google.com/finance?.....X&

  6. Eric says:

    If I hadn’t diversified earlier this year I would have lost some money. A few stocks that I bought in February and March of last year more than doubled in price, then they started going down this January. That is when I sold some and bought other stocks as well, which saved me some of the losses that I would have had to deal with had I kept just the stocks from last year.

  7. Zach says:

    Diversifying is a no brainer imo. If you had the bulk on your portfolio in tech stocks 10 years ago, you would be starting at square one all over again, the same could be said about companies in the financial sector over the past few years as well.

  8. Kevin K. says:

    Investing in one stock is like a gamble, best spreading out the risk over several areas by diversifying.

  9. kt says:

    diversification still works. i am currently reading the latest edition of security analysis and these money guys still insist that individuals and corporations alike must diversify. this is one of those things that go without saying.

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